Balloon mortgages were far more common before the 2008-09 financial crisis. Most mortgages these days are 15 or 30 year fixed rate loans. But balloon mortgages still exist.
In this article, we’re going to take a closer look at what a balloon mortgage is, how it works, and what home buyers need to know about the pros, cons, and dangers of these loans.
What is a balloon mortgage?
A balloon mortgage is a type of home loan, in which a flat balloon payment is charged at the end of the term.
To understand balloon mortgages, you need to know about them Loan write-off. This breaks your mortgage loan down into fixed monthly payments that cover principal, interest, and other expenses over time. A conventional loan will amortize your credit balance over the entire term of the loan. So if you get to the end, you don’t owe the bank anything. This doesn’t happen with a balloon mortgage.
With a balloon mortgage, the borrower makes payments for a period of time. Thereafter, the remaining principal amount is due in full with the final payment.
Balloon loans are used for a variety of types of financing, including buying a home.
How does a balloon mortgage work?
A balloon mortgage can work in a number of ways, but you always have to make a large balloon payment at some point. Here are some ways that balloon mortgages can be structured:
Balloon payment mortgage
This is the most common type of balloon mortgage. Loan payments are calculated according to a normal repayment schedule of 15 or 30 years. After a certain period of time – for example five or seven years – the remaining capital amount is due in a lump sum.
For example, let’s say you borrow $ 200,000 to buy a home. You choose a balloon mortgage with a 3% interest rate that is amortized over 30 years and the balloon payment is due after seven years. Your monthly mortgage payment would be $ 1,079 for principal and interest, according to The Ascent’s Mortgage calculator. After the seven year term of the mortgage, a principal of $ 167,561 would remain. And it would all be due immediately.
For the repayment period, you only pay interest on some balloon mortgages. This means that the borrowers only pay the monthly interest on the loan. The entire original principal is due at the end. This is most common in commercial real estate, but not uncommon in the residential mortgage market.
No monthly payments
There are also balloon mortgages with no monthly payments. These are usually short-term (e.g. one year). The accrued interest is then added to the final balloon payment. These balloon mortgages are often seen in fix-and-flip situations where an interesting year or two is viewed as part of the cost of a rehab project.
How do balloon mortgages compare to other types of loans?
Balloon mortgages are more risky than other types of loan, but there is usually one particular factor that appeals to borrowers. For example, a balloon loan could have a lower interest rate. Or it could be an interest-free loan product. In both cases, the monthly payment can be lower.
- Conventional Loans. The main difference between a balloon mortgage and conventional loan is predictability. They know exactly what your payment will be and how long you will be making payments. And you know when your home is being paid for. For more information on what is right for you, see our comparison of a 15 vs. 30 year mortgage.
- Adjustable rate mortgages. The interest rate for a Variable rate mortgage is fixed for a certain number of years (often five or seven). After that, it is regularly adjusted to market conditions. Most balloon mortgages are fixed-income because of the short-term nature of their term. A variable rate mortgage can be a great alternative to a balloon mortgage. You don’t have to make a large lump sum if you can’t sell or refinance after that first period.
- Government sponsored loans. FHA loans and USDA loans are not available as balloon mortgages. On FHA loans is aimed at borrowers who may not qualify for a conventional mortgage. This could be because their credit score is lower or they are unable to make a large down payment. ON USDA loan could help low-income borrowers in certain rural areas qualify for a home loan.
The biggest risk with a balloon mortgage is what could happen at the end of the term. Unlike some other types of loan, you owe a significant amount of money at once. If you can’t pay for it, you risk damaging your credit and potentially losing your home.
When are balloon mortgage payments due?
This depends on the particular loan. Seven-year balloon mortgages seem to be the most common, but you can also find five-year and ten-year repayment terms. Balloon mortgages as short as three years or up to 30 years are also possible.
In any case, the final balloon mortgage payment is the lump sum of all principal and accrued interest on the account.
In most cases, the borrower does not plan to make the balloon payment. Instead, the goal is to refinance or sell the remaining balance before the balloon payment is due.
- Sell your home. You may want to sell the home before you have to pay that lump sum. However, there is no guarantee that it will. Even if you can sell, there is no way of knowing if the value of the home will go up or down. No one can predict what the real estate market will look like five or seven years from now.
- Refinancing. Some people take out a balloon mortgage with a plan Refinancing before the balance is due. That’s an option, but be aware that interest rates can rise dramatically by then.
If a balloon mortgage could be a good idea for you
Balloon mortgages make most sense for borrowers who only want to own the home for a short period of time. This is especially true if you can find an interest-free balloon mortgage. Even then, balloon mortgages can be very risky.
Some cases in which balloon mortgages can make sense:
- Your credit is not great now, but you are confident that it will be significantly higher in the future. This way you can refinance before the balloon payment is due.
- You are only planning to be home for a few years and want to keep your monthly housing costs as low as possible.
- They anticipate interest rates will drop significantly over the next few years and plan to refinance at a lower interest rate in the future.